Commentary

Global turmoil calls for hedging with oil

Commentary: Oil services stocks offer growth, protection

GRAND BLANC, Mich. (MarketWatch) — In most years, the world eagerly awaits the signs of spring — warming temperatures, April showers and the May flowers that naturally follow. This year, the world is far more concerned about the dark clouds that March has delivered.

With the earthquake — and tsunami — in Japan and continuing unrest in North Africa and the Middle East, the fledgling global economic recovery is facing serious challenges in the months ahead.

TRADING STRATEGIES: MARCH
Trouble ahead?
Japan's crisis, turmoil in Europe and unrest in the Middle East have
investors worried that we’ll all be thrown back into the throes of global recession.

During such uncertain financial times, investors often look to gold as a store of value — which is certainly fine if you’re seeking a safe haven for your money. However, given the forces driving the markets today, and our outlook for oil prices, we recommend hedging your portfolio with “black gold” as well — specifically focusing on oil-services stocks.

On the basis of fundamentals alone, I began the year expecting oil to rise above $100 a barrel early in 2011, and I said as much Jan. 18, going “on record” in a national TV interview. However, in late January, a barrel of West Texas crude was trading in the mid-$80s.

When concern over the events in the Middle East kicked in a month later, oil headed well north of $100 a barrel, bolstered by the potential supply disruptions such conflicts in major oil-producing regions typically represent.

In mid-March, oil prices pulled back on the basis of potential demand disruptions linked to the disastrous earthquake, tsunami and nuclear crisis in Japan.

What the next short-term price driver will turn out to be is anybody’s guess, but one thing is certain — global geopolitical events will keep oil prices highly volatile for quite some time.

The key for smart investors is to view the volatility on the downside as a buying opportunity — one that will let them snap up oil-related stocks at bargain prices to hold for both long-term growth in the energy sector and as a hedge for other portfolio elements that might suffer from renewed economic concerns.

Regardless of the short-term swings, the longer-term outlook for oil — and oil prices — is bullish based on the supply/demand equilibrium.

As the U.S. economy continues to recover, domestic energy demand will continue to rise. Meanwhile, the thirst for oil in emerging-market economies will remain insatiable, even if their growth slows because monetary authorities raise interest rates to combat inflation.

Analysts can dispute the first claim, contending higher prices will cause demand destruction in the United States. But they can’t really argue the second since China’s growing demand for oil has continued virtually unabated — even when oil approached $150 per barrel in 2008.

We’ll also see a rebound from the short-term drop in energy demand caused by Japan’s catastrophes, which knocked a major portion of the country’s industrial production offline. Japan will turn to more traditional fossil fuels to replace its damaged nuclear complexes and rebuild essential infrastructure lost to the quakes and tsunami — and oil will be a major beneficiary.

What’s more, there will undoubtedly be a similar shift worldwide as the safety of other nuclear reactors is questioned, prompting protests and undoubtedly curbing expansion of this alternative to oil in meeting the world’s future energy needs.

The fundamentals aside, oil has also proven a fairly reliable hedge against what we call the “fear factor” — especially as it relates to daily stock-market volatility.

Hard assets — particularly gold and other precious metals — can play an important role in portfolio diversification since the metals have historically exhibited a very low correlation with the overall stock market. In fact, gold has typically shown a negative correlation (trading in the opposite direction) to the S&P 500 Index.

Oil displays similar behavior at times. On several days already this year we have seen the broad stock market move down while the price of oil and oil-related stocks have moved up. Even on the days when market sell-offs were blamed on worries over Egypt and then Libya, oil stocks rallied — often even more than gold.

Given that hedging potential, we urge investors who haven’t yet taken the dive into the oil patch based on fundamentals to diversify into “black gold” — augmenting your holdings in the shiny metals. While oil and oil-related stocks have had a good run over the past several months, the March pullback has provided an entry point for both newcomers and investors who are underweighted in this sector.

You could target the large integrated oil companies, which should have plenty of upside ahead, but we actually prefer the service-related stocks — those of drillers and equipment suppliers. For a diversified play in this sector, I’d point investors toward either of a pair of funds

ProFunds Oil Equipment, Services & Distribution FundOEPIX, +0.00%
— This mutual fund tracks the Dow Jones U.S. Oil Equipment, Services & Distribution Index
DJUSOQ, +0.02%
using leverage in an attempt to achieve returns equal to 150% of the movement in the Index. Founded in 2006, the fund’s net asset value (NAV) topped $50 a share before plunging in the economic collapse to around $7 in early 2009. Since then, the fund’s recovery has been solid, with a return over the past year of 36.5%.

iShares Dow Jones U.S. Oil Equipment & Services Index Fund IEZ, +0.90%
— This exchange-traded fund seeks to mirror the performance of the Dow Jones U.S. Select Oil Equipment and Services Index
DJSOES, +0.89%
holding a representative sample of the securities making up the index. IEZ traded near $79 a share in 2009, fell below $23 in early 2009, and has recovered steadily since, returning 38% over the past 12 months.

For stock pickers, the top holding in both of these funds is Schlumberger Ltd.SLB, +0.37%
– The world’s leading supplier of technology, integrated project management and information solutions to companies working in the oil and gas industry, SLB will benefit from the world’s increasing demand for oil and the quest for more and better methods to get it out of the ground. SLB, which traded above $105 a share in mid-2008, earned $2.86 a share in 2010, and the $1 dividend provides a yield of 1.15%.

Disclosure: Clients and employees of Mainstay Capital Management may hold the securities mentioned in this article in their investment portfolios. The securities mentioned may not be suitable for some investors, based on their tolerance for risk or their investment time horizon.

David
Kudla

David Kudla is CEO and Chief Investment Strategist of Mainstay Capital Management, a fee-only, independent, Registered Investment Advisor. More information about his firm can be found at www.mainstaycapital.com. Follow him on Twitter @David_Kudla.

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David
Kudla

David Kudla is CEO and Chief Investment Strategist of Mainstay Capital Management, a fee-only, independent, Registered Investment Advisor. More information about his firm can be found at www.mainstaycapital.com. Follow him on Twitter @David_Kudla.

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